Excessive inventory hurts performance because it requires additional capital, and there is a cost associated with this capital. If you can reduce your debt by trimming your inventory, your interest cost will fall, and this will increase your net income, trim your investment base, and raise your return on investment. To maximize your profitability, it is important that you manage your inventory well. This means the money tied up with your inventory should be balanced against what is required to sustain smooth operations.
The main goal of inventory management is to discover and maintain the inventory level that is best for your business. You must avoid having an inadequate inventory, which disrupts production and leads to lost sales, and an excessive inventory, which introduces unnecessary carrying costs and risks of the inventory spoiling or becoming obsolete. Your optimum or most desirable inventory level lies somewhere in between.
For most companies, the most important types of inventory are the following:
• Raw materials—the goods you buy from another company and then use to make your own goods
• Work in progress—partially completed goods in the process of production
• Finished goods—goods ready for sale
The costs associated with inventory management may be broken down as follows:
• Stock-out costs—the costs that your company incurs when it runs out of inventory to sell (which can result in lost sales) or use in production (which can result in production shutdown).
• Ordering costs—these usually consist of the clerical cost of preparing a purchase order or production order, and special processing and receiving costs (or handling costs) relating to the number of orders processed.
• Carrying costs—these usually consist of your desired rate of return on the investment in inventory (also called the opportunity cost of funds invested in inventory, since the funds tied up could have been invested elsewhere) and the costs of storage space, losses attributable to inventory breakage, deterioration or obsolescence, and insurance costs.
Your basic inventory problem is determining how much you must invest in inventory to operate normally; how much inventory you should acquire per order; and when you should place such orders to maintain your desired inventory level.
Your aim is to find the inventory level that minimizes your stockout costs, ordering costs and carrying costs. To find your optimal inventory level, weigh the benefit of carrying inventory against the potential costs of storage and obsolescence.
This balancing requires decisions on the following:
• Inventory investment versus customer service: The lower you inventory, the more back orders and stockouts you incur; the higher your inventory, the greater your customer service.
• Inventory investment versus cost of placing inventory replenishment orders: You keep your inventory low by frequently making small purchase orders. However, high set-up and order costs—as well as lost quantity discounts—result from frequently making small purchase orders.
• Inventory investment versus cost of storing inventory: A high inventory results in high storage costs and high risks of the inventory spoiling or becoming obsolete.